U.S. downgrade expected without grand bargain in next two months

While the fiscal cliff deal brought a big sigh of relief to the market, particularly for risk assets, the compromise does nothing to address the long-term budget problems facing the United States.

In fact, the Congressional Budget Office’s math suggests the bill increases the budget deficit by US$4-billion over the next 10 years. Most of this comes from lower revenues, but there is also another US$330-billion in spending increases through 2022.

“The fact that Republicans were willing to take a deal with no net spending reductions suggests to us that this group will now push hard for spending cuts in the upcoming showdown on the debt ceiling,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets. “To us, this is headline risk in the making.”

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In the absence of a grand bargain in the next two months, he warned the U.S. debt rating will likely be downgraded. Mr. Porcelli also cautioned that this should have a bigger market impact than the S&P downgrade in August 2011.

The economist noted that many investors look towards the most common rating of an issuer. So despite the AA+ rating from S&P, most could still count their Treasury and Agency MBS exposure in their AAA bucket.

However, if Fitch or Moody’s chooses to downgrade the U.S., then the AAA bucket gets much smaller. As a result, RBC noted that anyone targeting an average rating for their portfolio will need to go up in credit in the rest of their portfolio to maintain their average rating.

“We are less concerned about a downgrade impact on the level of Treasury yields or the slope of the curve as we are of this sort of cascade effect on other assets,” Mr. Porcelli and Michael Cloherty, RBC’s head of U.S. rates strategy, said in a report.

Moody’s was the first rating agency to comment on the deal: “The rating agency expects that further fiscal measures are likely to be taken in coming months that would result in lower future budget deficits, which are necessary if the negative outlook on the government’s bond rating is to be returned to stable. On the other hand, lack of further deficit reduction measures could affect the rating negatively.”

Meanwhile, Fitch has said “failure to avoid the Fiscal Cliff and raise the debt ceiling in a timely manner as well as securing agreement on credible deficit reduction would likely result in a rating downgrade in 2013.”

RBC expects the debt ceiling will be hit on March 1, 2013, when a Social Security payment is due to go out. However, Mr. Porcelli noted when the debt ceiling becomes binding is more uncertain than usual as it will depend in large part on the rate of tax refund distributions.

He thinks it is conceivable that refunds could be delayed, thereby pushing back the deadline. In an extreme scenario, the economist suggested the Treasury Department may be able to continue to operate past the April 15th tax date.